There Is Trouble Brewing at Two Defensive Tobacco Companies

After a record first half, tobacco stocks are now starting to pull back as the high-yield sector of the market is sold-off. During the first six and a half months of the year, Altria (NYSE: MO) matched the S&P 500 with gains of 17.5%, while Reynolds American (NYSE: RAI) climbed 24% and Philip Morris International (NYSE: PM) advanced 7.3%, all excluding dividends (the S&P 500 gained 18% over the same period). However, since the recent sell-off began, all three companies have wiped out most of their gains so far this year.

So is it time to take a position?

It could be, although there are several factors weighing on these companies that I am concerned about--and I'm not talking about the fact that they sell tobacco.

Rising debt, falling equity

Tobacco companies have been buying back shares in an attempt to offset declining sales and earnings. In particular, Philip Morris has been buying back huge quantities of stock, but this is at the expense of shareholder equity; the company has borrowed heavily to finance these buybacks.

Metric

2011

2012

Q1 2013

Q2 2013

Cash Flow from operations

$10.5

$9.4

$1.4

$3.1

Buybacks and Dividends

$10.1

$12.0

$3.0

$3.0

Figures in $ billions

Simply put, Philip Morris is spending more than it can afford on dividends and buybacks. During 2012, the company spent $2.6 billion more on investor returns than cash flow from operations provided, and the same can be seen for the first quarter of this year.

Metric

2008

2009

2010

2011

2012

2013E

2014E

2015E

Long-term debt

$11,377

$13,672

$13,370

$14,828

$17,639

$19,439

$21,725

$23,862

Fully diluted number of shares ...

$2,078

$1,950

$1,842

$1,762

$1,692

$1,607

$1,526

$1,445

Book Value per Share

$3.61

$2.93

$1.90

$0.13

-$2.05

-$3.28

-$4.96

-$6.71

Figures in millions

Applying this to long-term debt forecasts and the number of shares in issue, an astonishing trend appears. The company's book value per share will be-$6.71 by the end of 2015; considering the company has already committed to its buyback plan up to this point, this is almost a certainty.

Philip Morris' liabilities are far exceeding assets and total equity has rapidly declined. Now, I'm not saying that Philip Morris' debt is unsustainable; in fact, it is quite the opposite. Interest costs were covered 12x by EBIT during the first quarter of this year, and debt to EBITDA was only 1.2x at the end of 2012. However, what is concerning is that after Philip Morris has finished spending, what will happen to the debt? The company cannot continue spending indefinitely. It will need to pay down debt, and this will mean a reduction in shareholder returns.

Elsewhere

In comparison, Altria, which is all around more diversified and financially prudent than Philip Morris, has a much stronger balance sheet with stable net debt, positive shareholder equity and a positive book value per share.

Metric

2008

2009

2010

2011

2012

2013E

2014E

2015E

Total equity

$2,828

$4,104

$5,227

$3,715

$3,204

$3,746

$4,638

$5,060

Net debt

-$442

$10,089

$9,880

$10,419

$10,978

$10,126

$9,593

$9,443

Fully diluted number of shares ...

2,087.00

2,071.00

2,079.00

2,064.00

2,024.00

2,000.00

1,980.00

1,960.00

Book Value per Share

$1.36

$1.98

$2.51

$1.80

$1.58

$1.87

$2.34

$2.58

Figures in $ except for number of shares

The lower amount of debt gives Altria a much better-looking balance sheet with more financial headroom for sudden surprises or growth through acquisitions. Of course, this will mean slower EPS growth for Altria's investors. Indeed, Altria's EPS growth over the past five years has been 7% compared to Philip Morris' 12%. However, Altria's outlook is more stable; the financial headroom gives the company space to generate cash, raise finance for acquisitions and return more to investors via a dividend. In addition, Altria is significantly more diversified than Philip Morris, and for this reason the company should be around longer than its international peer.

Shareholder equity

In fact, Altria is the only big US-listed tobacco company that has positive shareholder equity. Well, actually, Reynolds also has positive shareholder equity, but the majority of this is goodwill.

Reynolds' balance sheet

Metric

Q2 2013

Inventory

$1,026

Trade debtors

$208

Cash

$1,664

Net debt

$3,918

Goodwill

$8,010

Total assets

$15,532

Total equity

$5,096

Total assets ex. goodwill

$7,522

Total equity ex. goodwill

-$2,914

*Figures in millions

Goodwill is an intangible asset and it is often considered to be more of a liability. Certainly any company with a large amount of goodwill on its balance sheet should be carefully scrutinized as accounting standards, write-downs and revaluations can quickly adjust goodwill. Adjust Reynolds' balance sheet to remove the goodwill and the company has a total equity value of -$2.9 billion.

Bigger problems

Reynolds has a bigger problem than negative equity. The company is facing the loss of 30% of its sales if menthol cigarettes are banned in the US. This issue has recently been reignited again after the FDA opened the discussion to public consultation last month. Meanwhile, Lorillard is facing total bankruptcy if menthol is banned, as nearly 90% of the company's sales come from menthol products.

Loss of menthol predictions

Metric

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Q3 2013

Q4 2013

Q1 2014

Q2 2014

Revenue

$2,117

$2,078

$1,883

$2,179

$2,062

$2,061

$2,060

$2,059

Revenue after the loss of menthol

$1,482

$1,455

$1,318

$1,525

$1,443

$1,443

$1,442

$1,442

EBIT margin

62.30%

47.90%

61.30%

36.00%

55.67%

45.08%

42.57%

40.05%

EBIT

$923

$697

$808

$549

$803

$650

$614

$577

Interest Costs

$56

$64

$68

$71

$74

$80

$84

$88

Interest as a % of EBIT

6%

9%

8%

13%

9%

12%

14%

15%

*Figures in millions

The EBIT figures I have used above are a prediction based on the company's revenue after a 30% loss of revenue. As the table shows, if this were the case, by the half-year 2014, Reynolds would be paying out 15% of EBIT in interest to finance is growing debt pile. Bear in mind also that the company's current dividend commitment runs at $350 million a quarter. Plus, a continuation of buybacks at the current rate of $150 million a quarter indicates that the company will find it hard to exist if menthol products are restricted, something I would not like to have hanging over my investment.

Conclusion

Borrowing to buy back stock is fine, but one day Reynolds and Philip Morris will have to pay back this debt. With tobacco consumption declining, paying back debt is going to become harder. As a long-term investment, Altria looks to be the best bet.

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